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Optimal Price Indices for Targeting Inflation Under Incomplete Markets

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  • Rahul Anand
  • Eswar S Prasad

Abstract

In models with complete markets, targeting core inflation enables monetary policy to maximize welfare by replicating the flexible price equilibrium. We develop a two-sector two-good new-Keynesian model to study the optimal choice of price index in markets with financial frictions. We find that, in the presence of financial frictions, a welfare-maximizing central bank should adopt flexible headline inflation targeting a target for headline CPI inflation with some weight on the output gap. These results are particularly relevant for emerging markets, where the share of food expenditures in total consumption expenditures is high and a large proportion of consumers are credit constrained.

Suggested Citation

  • Rahul Anand & Eswar S Prasad, 2010. "Optimal Price Indices for Targeting Inflation Under Incomplete Markets," IMF Working Papers 10/200, International Monetary Fund.
    • Handle: RePEc:imf:imfwpa:10/200
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    Cited by:

    1. José de Gregorio, 2012. "Commodity Prices, Monetary Policy and Inflation," Working Papers wp359, University of Chile, Department of Economics.
    2. Plante, Michael, 2014. "The long-run macroeconomic impacts of fuel subsidies," Journal of Development Economics, Elsevier, vol. 107(C), pages 129-143.
    3. Eswar S Prasad, 2014. "Distributional Effects of Macroeconomic Policy Choices in Emerging Market Economies," IMF Economic Review, Palgrave Macmillan;International Monetary Fund, vol. 62(3), pages 409-429, August.
    4. repec:kap:compec:v:51:y:2018:i:1:d:10.1007_s10614-016-9630-z is not listed on IDEAS
    5. repec:bok:journl:v:18:y:2012:i:2:p:1-28 is not listed on IDEAS
    6. Marc Pourroy & Benjamin Carton & Dramane Coulibaly, 2016. "Food Prices and Inflation Targeting in Emerging Economies," International Economics, CEPII research center, issue 146, pages 108-140.
    7. Anand, Rahul & Prasad, Eswar S. & Zhang, Boyang, 2015. "What measure of inflation should a developing country central bank target?," Journal of Monetary Economics, Elsevier, vol. 74(C), pages 102-116.
    8. Bhattacharya, Rudrani, 2017. "Effectiveness of monetary policy in stabilising food inflation: Evidence from advanced and emerging economies," Working Papers 17/209, National Institute of Public Finance and Policy.
    9. Chetan Ghate & Sargam Gupta & Debdulal Mallick, 2018. "Terms of Trade Shocks and Monetary Policy in India," Computational Economics, Springer;Society for Computational Economics, vol. 51(1), pages 75-121, January.
    10. Bhattacharya, Rudrani, 2016. "How does Supply Chain Distortion affect Food Inflation in India?," Working Papers 16/173, National Institute of Public Finance and Policy.
    11. Jaroslava Durčáková & Ondřej Šíma, 2015. "BRICS: Interconnection of Exchange Rate, Balance of Payments and Foreign Exchange Reserve - the Example of India," Český finanční a účetní časopis, University of Economics, Prague, vol. 2015(1), pages 6-35.
    12. Andrew Filardo & Marco Jacopo Lombardi, 2014. "Has Asian emerging market monetary policy been too procyclical when responding to swings in commodity prices?," BIS Papers chapters,in: Bank for International Settlements (ed.), Globalisation, inflation and monetary policy in Asia and the Pacific, volume 77, pages 129-153 Bank for International Settlements.
    13. Franz Ruch & Stan du Plessis, 2015. "Working Paper – WP/15/05- Second-Round Effects from Food and Energy Prices- an SBVAR approach," Papers 7008, South African Reserve Bank.
    14. Paolo Pesenti, 2013. "Theoretical notes on commodity prices and monetary policy," BIS Papers chapters,in: Bank for International Settlements (ed.), Globalisation and inflation dynamics in Asia and the Pacific, volume 70, pages 79-90 Bank for International Settlements.
    15. Rudrani Bhattacharya, 2016. "How does Supply Chain Distortion affect Food Inflation in India?," Working Papers id:11261, eSocialSciences.
    16. Changyong Rhee & Hangyong Lee, 2013. "Commodity price movements and monetary policy in Asia," BIS Papers chapters,in: Bank for International Settlements (ed.), Globalisation and inflation dynamics in Asia and the Pacific, volume 70, pages 71-77 Bank for International Settlements.
    17. repec:inu:caeprp:2013002 is not listed on IDEAS

    More about this item

    Keywords

    Economic models; Emerging markets; Consumption; Consumer price indexes; Demand; Food production; Inflation targeting; Inflation; Monetary policy; Price elasticity; Welfare; Monetary Policy Framework; Core Inflation; Headline Inflation; Financial Frictions; Liquidity Constraints; aggregate demand; central bank;

    JEL classification:

    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E61 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Policy Objectives; Policy Designs and Consistency; Policy Coordination

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